Q.46 bop-deficit-and-measures
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    Q.46 bop-deficit-and-measures Q.46 bop-deficit-and-measures Document Transcript

    • (a) What are the adverse effects of a persistent balance of payments deficit? [10] (b) Discuss the measures that the government can take to correct a persistent balance of payments deficit. [15] (a) The balance of payments (BOP) is a record of all the transactions between the residents of the economy and the rest of the world over a period of time. In other words, the BOP records all the money flows between the economy and the rest of the world. A BOP deficit occurs when money outflows exceed money inflows. Under the flexible exchange rate system, a persistent BOP deficit may lead to high imported inflation, high cost-push inflation, falling national income and rising unemployment. When money outflows persistently exceed money inflows, the supply of domestic currency persistently exceeds the demand and this leads to a persistent downward pressure on the exchange rate. Under the flexible exchange rate system, this will cause domestic currency to depreciate persistently. A persistent depreciation of domestic currency will lead to rising prices of imported goods and services, which include both consumer and intermediate goods, which may lead to high imported inflation. Further, the rising prices of imported intermediate goods may lead to high costpush inflation which may make domestic goods and services relatively more expensive than foreign goods and services. If this happens, the resultant decrease in net exports will worsen the BOP which may become a vicious cycle. A persistent depreciation of domestic currency may induce people to sell it in anticipation of further falls in the exchange rate. If this happens, the resultant currency instability may lead to falling inward foreign direct investments and hence falling aggregate demand resulting in falling national income and hence rising unemployment. Under the fixed exchange rate system, a persistent BOP deficit may lead to rising foreign debt, falling national income and rising unemployment. Under the fixed exchange rate system, when money outflows persistently exceed money inflows, the central bank will continually intervene in the foreign exchange market to eliminate the persistent downward pressure on the exchange rate of domestic currency. In other words, the central bank will continually buy domestic currency and sell foreign currency to prevent domestic currency from depreciating. However, in time to come, the central bank will run out of foreign exchange reserves and hence will have to start borrowing foreign currency from foreign banks which will lead to rising foreign debt. Further, if the central bank continually buys domestic currency, the money supply will fall continually which will lead to rising interest rates. The resultant falling investment expenditure and consumption expenditure will lead to falling aggregate demand resulting in falling national income and hence rising unemployment. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
    • In conclusion, a persistent BOP deficit may lead to adverse consequences for the economy, such as high imported inflation, high cost-push inflation, falling national income, rising unemployment or rising foreign debt, depending on the exchange rate system. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
    • (b) There are several measures that the government can take to correct a persistent BOP deficit: devaluation, protectionism, contractionary demand-side policies and supplyside policies. The central bank can devalue domestic currency to correct a persistent BOP deficit, assuming the economy operates under the fixed exchange rate system. A depreciation of domestic currency will lead to an increase in net exports and hence an improvement in the BOP. However, if the Marshall-Lerner condition does not hold, which may happen in the short run, a devaluation of domestic currency will lead to a deterioration in the BOP. Further, a weaker domestic currency will lead to a rise in the prices of imported goods and services, which include both consumer and intermediate goods, which may lead to high imported inflation. The rise in the prices of imported intermediate goods may also lead to high cost-push inflation which may render devaluation an ineffective measure for correcting a persistent BOP deficit. The government can use protectionist measures to correct a persistent BOP deficit. Protectionist measures include tariffs, import quotas, subsidies, etc. For instance, tariffs are taxes imposed on imports and they can be increased to push up the prices of imports to decrease the quantity. Import expenditure will decrease which will lead to an improvement in the BOP. However, the immediate cost of increasing tariffs is higher prices for consumers. In addition, protectionism reduces competition for domestic firms which may foster inefficiency. Devaluation and protectionism are subject to several common limitations. First, if the root cause of a persistent BOP deficit is high production cost or low product quality, devaluation and protectionism will not solve the underlying problem. Second, if the economy’s trading partners retaliate, the fall in import expenditure may be offset by a fall in export revenue, leaving the BOP unchanged. Third, even in the absence of retaliation, export revenue may fall if protectionism leads to a fall in the national income and hence the imports of the economy’s trading partners. The government can use contractionary demand-side policies to correct a persistent BOP deficit. The government can decrease aggregate demand by decreasing expenditure, increasing direct taxes, decreasing transfer payments or decreasing the money supply to raise interest rates. A decrease in aggregate demand will lead to a fall in national income and hence imports which will lead to an improvement in the BOP. A decrease in aggregate demand will also lead to a fall in the general price level which may make domestic goods and services relatively cheaper than foreign goods and services resulting in an increase in net exports. If this happens, assuming the demand for exports is price elastic, the BOP will improve. However, contractionary demand-side policies will lead to a fall in the standard of living and a rise in unemployment. Further, the effect of a fall in national income on the BOP may be small if the marginal propensity to import is small. Contractionary demand-side policies are also subject to limitations such as inflexibility of government expenditure and taxation and the effectiveness time lag. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
    • The government can use supply-side policies to correct a persistent BOP deficit. The government can use education and training and research and development to increase aggregate supply. An increase in aggregate supply will lead to a fall in the general price level which may lead to an increase in net exports. If this happens, assuming the demand for exports is price elastic, the BOP will improve. However, an increase in aggregate supply will lead to an increase in national income and hence imports which will cause the BOP to deteriorate. Further, supply-side policies are subject to the limitation of a long effectiveness time lag. In the final analysis, although a persistent BOP deficit can be corrected with a few measures, the limitations of the measures may lead to problems that are more detrimental than a persistent BOP deficit. Further, the measures may not solve the root cause of the problem. For instance, a main cause of the huge trade deficit of the United States is the problem of consumerism, which a rise in interest rates can only go some way towards reducing it. Therefore, if the government deems necessary to correct a persistent BOP deficit, it should take into consideration the limitations of the measures and the root cause of the problem. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek